Feedback from derivatives proposals in the EU & India (Aug 2010)

As some countries try to legislate new regulations to govern the existing market for derivatives, other countries are developing the new rules to introduce derivatives to their own markets and several debates about the pros and cons of such actions are heating up.

Europe:

• The EU is in the process of drafting a new law that would impose fines on institutions that fail to report trade details in OTC derivatives “no later than the working day following the execution” of the trade” according to Bloomberg.
• As the EU proposal could only be properly enforced within the EU, derivative trading could shift away from London and the rest of the EU to offshore or other international financial centers as well as creating a disadvantage for EU-based institutions relative to other foreign (primarily US-based) institutions.

India:

• India previously released their new draft guidelines detailing the introduction of corporate credit default swaps last month and now some critics are voicing their concerns that with too much regulation, the market may fail to ever pick up.
• A major concern is ensuring the inclusion of foreign institutional investors (FII’s) in order to provide more liquidity on both sides of the market. According to Ramit Bhasin, head of Indian markets at RBS, in an interview in The Economic Times, “FIIs now comprise a fairly significant portion of the corporate debt market and there is very good reason that they be added to the list of participants permitted in the CDS space.”
• Another related concern to the above point is the potential lack of participation by Indian public sector banks (mostly state-owned banks) which according to The Financial Express, own 70% of the banking assets in India but are reluctant in dealing with derivatives and other structured products. For example, in the interest-rate swap market, “PSU banks hold only 0.63% market share generating Rs 650 crore of business……(inclusive of buys and sells) while foreign banks hold 78.70% with Rs 81,218 crore volume.” The historical reluctance on participation in newer innovative financial products lies in their risk taking abilities. “If a PSU bank incurs losses in derivative market due to a dealer’s wrong call, it is treated more of a criminal offense rather than a financial loss. Vigilance steps into action. This holistically brings down the risk taking ability of PSU bank dealers.”
• Lack of clarity on who, how and when a credit event will be determined (to trigger CDS contractual payouts). The ET talked to Hemant Mishr, head of global markets for Standard Chartered on the issue who talked about how “RBI should also examine the possible role of asset reconstruction companies (ARCs) in the CDS market. ARCs’ and other entities dealing in distressed assets have a role to play in the event of default cases, given their specialisation in price discovery in such cases.”
• The concept of novation, or replacing existing counterparties in a derivative, in order to trade in/out of CDS in secondary markets is currently not provided for in the user group of the derivatives. Users are so far only able to unwind/re-hedge an existing CDS purchase with the original market-maker counterparty. This setup is seen to be favouring CDS protection-sellers (which are primarily the market-makers/banks) at the expense of the corporate users that are also supposed to benefit.
• The lack of flexibility in matching underlying bond maturities with varying CDS tenures. This could create arbitrage-like opportunities and differences in liquidity similar to those in government bond curves between on-the-run and off-the-run benchmark bonds.
• CDS in India is only provisioned for corporate bonds of 1-year to maturity or greater. Critics argue the risk management benefits of a CDS should also be allowed or expanded to cover the important money markets in India which include certificates of deposits (CD’s) and commercial paper.
• The need (or lack of a need) for credit ratings on the underlying corporate bonds.